Gold

Wright's Model

Negative yield curves have proved to be reliable
predictors of economic recession over the past 50 years. However, recent experience in
the United Kingdom and Australia raises questions as to whether this
relationship still applies: both economies have coped with inverted yield curves for some
time while enjoying robust growth.

Jonathan Wright, a research economist at the Federal Reserve, in his paper
titled The
Yield Curve and Predicting Recessions, tested the
ability of various models to predict recessions. While his study confirmed a significant
and relatively stable relationship between the yield differential
(or spread) and subsequent recessions,
Wright found an important second variable that substantially improved predictive
ability. Wright's model shows that chances of
recession are
significantly less than when the funds rate is low -- even if the yield
differential is negative. This is best
illustrated by comparing output from the model with the fed funds rate set at
3.5% and at 5.5%. The spread is calculated as the difference between ten-year and
three-month US Treasury securities.

Probability of recession within the next 4
quarters

Fed Funds Rate:

3.5%

5.5%

Spread: 1.0%

4%

16%

Spread: 0.0%

17%

40%

Spread: -1.0%

43%

70%

If the fed funds rate is low, the probability of a recession is also low unless the
yield
curve becomes inverted.
However, if the fed funds rate is high, there is significant (40%) probability of a recession
when the yield curve is flat, increasing to high probability when the yield
curve is negative (70% at -1.0%).

The above chart plots the yield on 13-week T-bills (a fair
approximation of the fed funds rate) against the S&P 500 index. The last
time the yield curve inverted was at [a] when short-term yields were above 6.0%.

The Yield Curve and Monetary Policy

A flat or inverted yield curve is normally caused by the Fed tightening
monetary policy, driving up
short-term rates to slow the economy
and contain inflation. Recently, however, short-term
rates have been at historically low levels and the flat yield curve is due to historically low long-term yields -- caused by
low term premiums and low inflation expectations among other factors. Wright
holds that when a flat yield
curve is caused by factors other than tight monetary policy, its predictive
ability is significantly reduced.

The above chart compares the S&P 500 index to the yield on 10-Year
T-Notes and the Yield Differential (between 10-Year
T-Notes and 13-Week T-Bills). The yield curve
inverted at [a] and was followed by a sharp fall in the S&P 500. Note the
historically low long-term yields (below 4.6%) experienced from mid-2002 until
early 2006.

Reading a Yield Curve

In a normal market, short-term securities yield lower
returns than those with longer maturity -- investors require a premium to tie up
their money for a longer period (a term premium). If we plot the yields on a graph, you will see
that the yield curve slopes upwards, with longer
maturities returning higher yields. However, there are times when the market
inverts and short-term yields exceed long-term yields. The yield curve then
slopes downwards and is referred to as a negative (or inverted) yield curve.

Signals

Negative yield curves
have proved to be reliable predictors of future recessions. This predictive
ability is enhanced when the fed funds rate is high, signaling tight
monetary policy.

A flat yield curve is a moderate bear signal for equity markets.
Banks suffer from a margin squeeze, as they pay mostly short-term rates to depositors while charging long-term
rates to borrowers, and are reluctant to extend new credit.

A negative yield curve is a strong bear signal.
Normally caused by the Federal Reserve raising short-term interest
rates to slow the economy, investors may contribute by driving long-term yields
down -- switching out of equities into more secure investments.

A steep yield curve is generally bullish for stock investors.
The
Fed may drive down short-term interest rates to stimulate the economy and
investors contribute by switching out of bonds into equities, causing long-term yields to rise.

Yield Differential (or Spread)

The yield differential
plots the difference between ten-year
Treasury notes and 13-week Treasury bills as an approximation of the yield
curve:

INTEREST RATES, RECESSION OR DEPRESSION? Reproduced with kind permission from Aubie Baltin. Before we can even begin to discuss interest rates intelligently, we must first define what it is that we are actually talking about ...